Introduction to Finance - Term Paper Example

«Introduction to Finance» One of the most comprehensive explanations of finance as a business concept was given by Groppeli and Nikbakht. They declared that finance is the application of a number of financial economic principles in order to create and maximize wealth or the overall value of a business (4). From this explanation it is safe to surmise that finance is all about money – how people and organizations spend it, allocate it, in such a way that brings in profits and returns as well as the opposite in the events of risks and bad financial decisions, among other variables (including its management). Today, finance is highly revolutionized, efficient and integrated because of the advent of technology and the Internet. This is particularly important because such development factors in the way the maximization of wealth differs from the sheer goal of profit maximization. These variables – technology, the Internet and even globalization – highlight how finance is all about wealth, its maximization by dealing with the uncertainty of the real-world environment. Finance: Background Finance per se is a general subject. It involves several other sub concepts that must be examined in order to cover its entirety. But first, a discussion of this main subject follows. Wealth is the main consideration in the area of finance. That is why it is mainly concerned with its maximization as well as the valuation and management of risks that can threaten such endeavor. With this in mind, finance qualifies as a discipline that permeates all business activities. Coles (1997) provided a detailed demonstration on what finance is and how it works. To quote: It is clear that while many businesses are worth considerable amounts of money they may have little cash in the bank… An entrepreneur who pays £1000 into the bank of a new business venture is clearly providing cash measured in money terms (a currency). The business is said to be financed or funded with £1000 and the owner’s interest in the business (called capital) is valued in money terms to the extent of the same £1000. If the business subsequently receives a bank loan of £500, this too is a source of finance that provides funds for items to be purchased (1). Arthur Keown listed ten principles in which finance is built and from which techniques, tools and strategies of wealth creation is commonly anchored on. These are: 1. the risk-return trade-off – the rejection of the assumption of risk unless there is an expectation of compensation with additional return; 2. the time value of money – the principle that considers the dollar received today is worth more than a dollar that would be received in the future; 3. that cash is more important than profits; 4. incremental cash flows – it’s only what changes that counts; 5. the challenge posed by the competitive markets wherein finding exceptionally profitable projects is difficult; 6. the efficiency of the capital markets; 7. the human factor wherein employees won’t work for the owners of a business unless it’s in their best interest; 8. taxes influence business decisions; 9. that risks are different – some of it can be diversified and some, not; and, 10. ethics in finance is the right thing but that ethical dilemmas abound (25-26). The following is a discussion of important financial concepts, which include: the legal forms of business – from sole proprietorship, partnership, to the corporation; the tax environment; financial management; financial markets; and, financial regulation as well as important dimensions to the subject like globalization and the role of technology in finance trends. Forms of Business Financial enterprise is not restricted to huge corporations such as IBM or Starbucks. The fact is that there are many forms and sizes of business organizations and that they are classified into three types: sole proprietorship, partnership and corporation. The most important differences in these business types, particularly in the context of dispensing financial decisions, include the way each is taxed; the degree of control that the owner(s) exert on decision-making; the liability of the owners; the degree of difficulty in the transfer of ownership; the capability to raise additional funds; and, the longevity of the business (Fabozzi and Drake 2009). Sole Proprietorship: Out of all the three business types, sole proprietorship is the easiest form of business to setup. The law sees this kind of enterprise in about the same way that it sees a private citizen. What this means is that a sole proprietor has the freedom as well as the flexibility in most of his management and financial decisions. Being the sole boss means easier efforts, say, in switching the nature of the business from one field to another or moving the shop to another place, among others. The downside however is that the proprietor has the sole responsibility for debts and financial liabilities that the business would incur. The financial capital would have to be sourced from his pockets and he makes a profit, it will be taxed as a personal income. Partnership: essentially, this is when two or more people pool their resources together by forming a partnership. The law treats this type of enterprise almost like the sole proprietorship because setting it up is less complicated and that the partners only have to agree on decision-making. There are two forms of partnership: the general partnership and the limited partnership. The former is not unlike the sole proprietorship except that the partners are involved in decision-making instead of a sole owner. A limited partnership involves limited partners who just want to invest and not be involved in the actual operation and decision-making of the organization. Corporation: the structure of this enterprise provides the greatest business and personal asset protection of any entity. When a corporation is formed, in the eyes of the law an entity also emerges. What this means is that “it can sue and be sued (even by its owners), buy and sell in its own name, must pay its own taxes, can sell stock in itself, borrow or lend money. It may be transferred from one set of owners to another, and survive the death of its original ownership” (Kiplinger 15). The bylaws, which serves as the rules of governance and conduct within the organization define the rights as well as the duties of officers therein, including the members of the board of directors and the shareholders. Usually, corporations are large entities and that owners no longer participate in the management and operation of the corporation. In this respect, a board of directors is elected to represent them in the decision-making and in monitoring the activities of the management employed to run the organization (Fabozzi and Drake 93). There is no exact science or methodologies that will determine which of these setups are the best or maximize the most profits. In the end, the efficacy of the business model rests on the ability of the owners or those tasked to manage it to maximize wealth – with all the resources available at their disposal within their respective environment – and mitigate financial risks. Tax Environment From the perspective of finance, taxes are one of the most important variables that influence business decisions. It is levied by governments and by establishments on property, income and products and services that are sold. Basically, there are three taxable entities according to the law: the individual, which include partnerships, the corporation and the fiduciary. Needless to say, taxes are difficult to avoid but that it could harm or boost the financial chances of a business enterprise. This is the reason why players in the financial world, specifically the financial managers, have to be acquainted with the basic concepts of taxes in both the domestic and international setting. There are various tax schemes legislated by countries. For example, and as has been stated earlier, the type of business enterprise is taxed differently wherein the profit of the owner in partnership and sole proprietorship are taxed as personal income of the owners, while in the corporation it is not. In finance, the issue of taxation is too significant to be ignored because it is part of the decision-making process. The relationship, particularly for corporations, according to Keown, are grounded in the taxability of investment income and the differences in tax treatment for interest expense and dividend payments and that, in addition, the shareholders’ tax status significantly affects their preference on the gains from stock and dividends. Financial Management Financial management concerns itself with the activities within the company that is financial in nature. More specifically, it is manages these activities for the purpose of maximizing profits, raising funds – creating wealth for the organization and its owners. A formal definition by Nieuwenhuizen and Machado (2004) states that the financial management is all about, “the responsibility for acquiring the needed financial resources and ensuring the best use of these resources over the short and long term” (320). Since business activity, wrote Coles, is measured in monetary terms and that business decisions are based on this information, financial management covers three main disciplines, namely: 1. Treasury department – concerned with making financial transaction and planning how the business should be funded to pay for the resources it requires; 2. Financial accounting – concerned with the recording of financial transactions and the preparation of financial reports to communicate past financial performance; 3. Management accounting – looking to the future, using knowledge of past performance where relevant to aid the management of business (2). The above disciplines underscore how the financial system allows for the acquisition of resources as well as generation of data from the processes involved, which are used as resources for better financial management and business decisions either to maximize wealth or to mitigate risks. Financial regulation Finance and Globalization After the dissolution of the USSR and the collapse of communism that came as a consequence, the capitalist economic model gained momentum. The free market system spread all over the globe that eventually lead to the increased integration of global markets and the erosion of national boundaries as individuals and firms look beyond their respective countries in their drive to maximize wealth. The increased interdependence of nations led to the economic model that is characterized by the rapid internationalization of trade, production and finance. In the specific context of finance, there is now the existence of a rapid mobility of capital that consistently erodes the capability of countries to control their own fates. What happened was that old-fashioned financial barriers by nation-states are swiftly being dismantled that enabled international finance to shift from tangible capital to the speedy alternative – one that is characterized by sophisticated data, information and other related elements. According to Robert Went capital and finance has more leverage now more than ever on nation-states, “being able – if considered necessary for profitability – to (threaten to) move goods and services, finance, and/or production facilities to pressure national and/or regional constituencies into more capital-friendly policies” (101). Bello (2000) emphasized this when he maintained that the globalization of finance reflects that “increasingly its dynamics serve as the engine of the global capitalist system” (in Bullard and Malhotra 4-5). The result is that the modern economic landscape is more profitable for those that accumulate financial assets instead of those who invest real projects. This is demonstrated, for instances, in foreign exchange, the subject of a section elsewhere in this paper. Grahl (2001) explained more in detail why finance now dominates the global norms of profitability: Banks draw and place funds within an essentially globalized payments system, and the terms on which they do so are externally determined. Central banks certainly have some influence on the day-to-day price of these funds, but this influence is tightly constrained and has to be exercised in a way that does not threaten the stability of bond yields. Bonds are now globally traded but also globally priced (35-36). Indeed, the 1990s saw how international banks have diversified and specialized their financial products and services, which included the introduction of new breeds of securities, mortgages, credit instruments, mutual fund, bonds, insurance products and other financial schemes resulting from their combinations. Finance and Regulation Although globalization has effectively eroded the nation-states’ sovereignty especially in economic terms, there are still elements that are under the state’s control. This includes tax, explained previously, and the financial regulation. Financial regulation includes a country’s monetary policy, among other regulatory initiatives that is anchored on a government’s responsibility for soundness especially that an event of financial crisis is a matter of public concern. For example, back in the 80s a major systematic crisis was avoided purportedly on account of the US Federal government’s regulators. For example, “the Fed persuaded Chase Manhattan to absorb a substantial portion of Drysdale’s losses on the grounds that it had acted as agent for the government securities dealer. Had the Drysdale default occured after the failure of Penn Square Bank and the Mexican crisis, Chase might not have been able to absorb these losses without seriously undermining public confidence in the bank” (D’Arista 176). Finance and Technology Two things revolutionized the way finance activities and transactions are conducted today: technology and the Internet. These two elements brought about the so-called electronic finance – that platform which is able to provide financial services as well as the coverage and creation of new financial markets by way of information technology, telecommunications and the Internet. An excellent example of this development in finance is e-banking. Here, banking services and products can be accessed in an online banking system, using advanced technologies and web other computing applications. Gkoutzinis (2006) stressed that “from an economic perspective, information technology and computer networks have enhanced the automation, speed and standardization in communications and internal administration, increasing customer convenience and functionality and reducing costs in back-office and front desk banking functions” (8). Another example from the strictly financial perspective by technological is the use of the credit card. This tool of exchange has already assumed the role of a currency. When one wishes to purchase a product or service, the “plastic card” is swiped in an electronic device or its number is entered into a terminal that launches a complex but speedy process wherein finance is disbursed, debited, billed, and recorded, among other things. Technology and the Internet have also stimulated innovations in other financial fields such as the financial market, foreign exchange, production, among many other business processes. In tandem with communication, the flow of capital no longer has to factor in variables of geographical distance, time and other barriers tagged with the independence of nation-states. Conclusion The study of finance is more important than ever because of the rapid changes it has undergone these past decades. Particularly, the impact of globalization and technology is widely felt in the field. And so, although a number of the traditional finance structures, disciplines and principles are still in place, they are significantly modified by internationalization. The experience of people from the far reaches of the globe is affected by financial decisions made in the headquarters of American financiers. There are new experiences that have to be examined in order to learn from them. Successes and failures in efforts to maximize wealth abound and, certainly, new efficient economic and business models can emerge in order realize financial objectives. Works Cited Bullard, Nicola and Malhotra, Kamal. Global finance: new thinking on regulating speculative capital markets. New York: Zed Books, 2000. Coles, Martin. Financial management for higher awards. Butterworth-Heinemann, 1997. D'Arista, Jane. The Evolution of U.S. Finance: Federal Reserve monetary policy, 1915 1935. New York: M.E. Sharpe, 1994. Fabozzi, Frank and Drake, Pamela. Finance: Capital Markets, Financial Management, and Investment Management. John Wiley and Sons, 2009. Kiplinger Washington Editors. Kiplinger's Personal Finance. Vol. 5: 6, 1951. Grahl, John. “Globalized Finance and the Challenge to the Euro.” Paper prepared for the Macroeconomics workshop of the Thematic Network, “Full Employment in Europe.” Memorandum Group. 2000. 20 Sept. 2010. Gkoutzinis, Apostolos. Internet banking and the law in Europe: regulation, financial integration and electronic commerce. Cambridge University Press, 2006. Groppelli, Angelico and Nkbakht, Ehsan. Finance. New York: Barron's Educational Series, 2006. Nieuwenhuizen, Cecile and Machado, Ricardo. Basics of Entrepreneurship. Cape Town: Juta and Company, Ltd., 2004. Went, Robert. The enigma of globalization: a journey to a new stage of capitalism. London: Routledge, 2002. Read More